As QE2 (second round of Quantitative Easing) enters its final 6 weeks, institutional investors appear to be adjusting their portfolios in anticipation of the Fed's Safety Net being pulled away to reduce the risk exposure in their portfolio.  Others are lightening the load as we enter what are typically the weakest months of the year.  While the majority of the clients and prospects we talk to understand that the Fed has been the primary reason the market has risen since 2009 and that it will end badly when they are no longer printing new money, we are seeing a handful of people asking why they shouldn't go back into (or stay with) <Fill in the blank> mutual fund rather than paying advisory fees. no longer being there to boost returns. 

Mutual Fund Flows Tell the Story

This Fed induced Bull Market appears to be no different.  Stock mutual funds saw a record amount of inflows in 2007 ($90 Billion) -- just before the housing bubble burst.  From there individuals sold their stock funds in large amounts.  Some of the heaviest selling came just before the market bottomed in March 2009 ($50 Billion in 2 months).  They were net buyers of stock funds in the summer months before they entered another wave of selling in the fall of 2009. 

There were only 3 months from September 2009 through October 2010 where there were net purchases of stock funds -- January 2010 (just before the market lost 8%) and March & April 2010 (just in time for the flash crash and the subsequent 17% drop in the S&P 500.)  It wasn't until November 2010 before individuals were ready to start purchasing stock funds again.

Despite the low interest rates, bond mutual funds have been widely popular. 

Repeating Past Mistakes

Using the recent past as the guide towards where to invest for the long-term is not something new.  Individuals have been making this mistake over and over again.  The cost of this "recency" bias is painful.  Investor Behavior Research Firm, Dalbar has documented the returns of individual investors over the years.  Here are the results for the 20 years ended in 2009:

SEM was founded in 1992.  Since then the S&P has annualized an 8.3% return, while bonds have annualized a 6.4% return.  Our most conservative program, Income Allocator has annualized 9.1%.  Enhanced Portfolio Allocator, our "balanced" program has annualized an 11.3% return, while our most aggressive program, Enhanced Growth Allocator has annualized 13.5%.  These returns are net of our maximum fees.  While past performance is not indicative of future results, our results compared to both the average equity investor and the S&P 500 show the value of reducing risk AND removing emotion from the investment decision.

Emotions Get in the Way

According to Dalbar, the reason investors under-perform the market by so much is that they make emotional decisions.  When the market starts dropping they panic and sell at the point of maximum pain.  They do not buy back in until it has risen substantially, often times after hearing about it in the media.  Dalbar put together the following chart to illustrate the stages of a bubble.  You would think that after experiencing the dot-com bubble followed by the real estate bubble, that investors would have learned their lesson.  Sadly it appears that many are once again falling for this emotional trap--not wanting to be a part of it until after the easy money has been made.  Look again at the mutual fund flow data.  The average mutual fund investor did not participate at all in the bull market from 2009-2010.  They put money into the market just before it went through large losses in January & the spring of 2010 and now that it has gone up for two years, are once again buying stock funds.

We've already seen one bubble burst -- the commodity bubble.  It appears that commodities have entered the "Blow off" phase after bursting a few weeks ago.  There may be rallies here and there, but as the speculators and late-comers flee, it is very risky to try to catch the bottom in that market. 

The stock market is not far behind.  (Typically a pick-up in volatility in commodities is a precursor to problems ahead for the stock market.)  Based on the phone calls and meetings we are having it is likely we are pretty far along in the "Mania" phase for the stock market.  Some individuals seem to already be at the "new paradigm" point, while others are down at the "enthusiasm" stage.  Either way, we are rapidly approaching the "blow off" phase, which is the point you NEED an experienced manager that has successfully navigated all of the bubbles over the past 20 years.

Controlling Emotions

One of the things I always try to do when somebody is wanting to increase their exposure to the market is to ask "why" they suddenly have a higher risk tolerance.  Having an older risk tolerance questionnaire is helpful because then we can ask "what" has changed for them personally since they filled out the last questionnaire.  Sometimes there are legitimate reasons (like they were unemployed before or uncertain about their job).  Most of the time the only reason they have changed their risk tolerance is because the market has gone up (or down).

The purpose of our ENCORE Portfolios is to provide a well diversified portfolio that gives our clients something they can stick with.  If they have a legitimate reason to be increasing their risk tolerance, we can increase their exposure by moving more money to something like Enhanced Growth.  Moving just a portion of the money ratchets up their market exposure without going back to a strategy that is guaranteed to participate in all of the downside (buy & hold investing).

This industry is tough.  If it were easy, everybody would be managing their own money and getting rich because of it.  We've put tens of thousands of hours into our research and are still far from perfect.  All we can hope for is that our rigorously tested systems along with our 19+ years of experience can continue to reduce risk and capture enough of the upside to continue moving forward.  By taking the emotion out of the decision making process we do not fall into the trap that stings most investors.